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SELECTION AMONG

ALTERNATIVES

Engr. Charity Hope Gayatin

Learning Unit Objective

to evaluate correctly capital investment alternatives when the


time value of money is a key influence.

Making decisions means comparing alternatives.

In this chapter we examine feasible design alternatives.


The decisions considered are those selecting from among a
set of mutually exclusive alternativeswhen selecting one
excludes the choice of any of the others.

Mutually exclusive alternatives (MEAs)

We examine these on the basis of economic considerations


alone.
The alternatives may have different initial investments and
their annual revenues and costs may vary.
The alternatives must provide comparable usefulness:
performance, quality, etc.
The basic methods for determining project profitability
provide the basis for economic comparison of the
alternatives.
The alternative that requires the minimum investment of
capital and produces satisfactory functional results will be
chosen unless the incremental capital associated with an
alternative having a larger investment can be justified with
respect to its incremental benefits.
This alternative is the base alternative.

For alternatives that have a larger investment than


the base
If the extra benefits obtained by investing additional capital are
better than those that could be obtained from investment of
the same capital elsewhere in the company at the Minimum
Attractive Rate of Return (MARR), the investment should be
made.
(Please note that there are some cautions when considering
more than two alternatives, which will be examined later.)

There are two basic types of alternatives.

Investment Alternatives
Those with initial (or front-end) capital investment that
produces positive cash flows from increased revenue, savings
through reduced costs, or both.
Cost Alternatives
Those with all negative cash flows, except for a possible
positive cash flow from disposal of assets at the end of the
projects useful life.

Select the alternative that gives you the most


money!
For investment alternatives the PW of all cash flows must be
positive, at the MARR, to be attractive. Select the alternative
with the largest PW.
For cost alternatives the PW of all cash flows will be negative.
Select the alternative with the largest (smallest in absolute
value) PW.

Investment alternative example


Use a MARR of 10% and useful life of 5 years to select between
the investment alternatives below.
Alternative
Capital investment

Annual revenues less expenses

-$100,000

-$125,000

$34,000

$41,000

Both alternatives are attractive, but alternative B provides a


greater present worth, so is better economically.

Cost alternative example


Use a MARR of 12% and useful life of 4 years to select between
the cost alternatives below.
Alternative

Capital investment

-$80,000

-$60,000

Annual expenses

-$25,000

-$30,000

Alternative D costs less than alternative C, it has a greater PW,


so is better economically.

Pause and solve


Your local foundry is adding a new furnace. There are several
different styles and types of furnaces, so the foundry must
select from among a set of mutually exclusive alternatives.
Initial capital investment and annual expenses for each
alternative are given in the table below. None have any market
value at the end of its useful life. Using a MARR of 15%, which
furnace should be chosen?
Furnace
F1

F2

F3

$110,000

$125,000

$138,000

Useful life

10 years

10 years

10 years

Total annual
expenses

$53,800

$51,625

$45,033

Investment

Determining the study period.

A study period (or planning horizon) is the time period over


which MEAs are compared, and it must be appropriate for
the decision situation.
MEAs can have equal lives (in which case the study period
used is these equal lives), or they can have unequal lives,
and at least one does not match the study period.
The equal life case is straightforward, and was used in the
previous two examples.

Unequal lives are handled in one of two ways.

Repeatability assumption
The study period is either indefinitely long or equal to a
common multiple of the lives of the MEAs.
The economic consequences expected during the MEAs
life spans will also happen in succeeding life spans
(replacements).
Co-terminated assumption: uses a finite and identical study
period for all MEAs. Cash flow adjustments may be made to
satisfy alternative performance needs over the study period.

Comparing MEAs with equal lives.


When lives are equal adjustments to cash flows are not
required. The MEAs can be compared by directly comparing
their equivalent worth (PW, FW, or AW) calculated using the
MARR. The decision will be the same regardless of the
equivalent worth method you use. For a MARR of 12%, select
from among the MEAs below.
Alternatives
A

-$150,000

-$85,000

-$75,000

-$120,000

Annual revenues

$28,000

$16,000

$15,000

$22,000

Annual expenses

-$1,000

-$550

-$500

-$700

Market Value (EOL)

$20,000

$10,000

$6,000

$11,000

10

10

10

10

Capital investment

Life (years)

Selecting the best alternative.

Present worth analysis select Alternative A (but C is close).

Annual worth analysisthe decision is the same.

Using rates of return is another way to compare


alternatives.

The return on investment (rate of return) is a popular


measure of investment performance.
Selecting the alternative with the largest rate of return can
lead to incorrect decisionsdo not compare the IRR of one
alternative to the IRR of another alternative. The only
legitimate comparison is the IRR to the MARR.
Remember, the base alternative must be attractive (rate of
return greater than the MARR), and the additional
investment in other alternatives must itself make a
satisfactory rate of return on that increment.

Use the incremental investment analysis procedure.

Arrange (rank order) the feasible alternatives based on


increasing capital investment.
Establish a base alternative.
Cost alternativesthe first alternative is the base.
Investment alternativesthe first acceptable alternative
(IRR>MARR) is the base.
Iteratively evaluate differences (incremental cash flows)
between alternatives until all have been considered.

Evaluating incremental cash flows

Work up the order of ranked alternatives smallest to largest.


Subtract cash flows of the lower ranked alternative from the
higher ranked.
Determine if the incremental initial investment in the higher
ranked alternative is attractive (e.g., IRR>MARR, PW, FW, AW
all >0). If it is attractive, it is the winner. If not, the lower
ranked alternative is the winner. The loser from this
comparison is removed from consideration. Continue until
all alternatives have been considered.
This works for both cost and investment alternatives.

Incremental analysis
Initial cost
Net annual income
IRR on total cash flow

Alt. A

Alt. B

Alt. B-Alt. A

-$25,000

-$35,000

-$10,000

$7,500

$10,200

$3,200

15%

14%

11%

Which is preferred using a 5 year study period and MARR=10%?


Both alternatives A and B are acceptableeach one has a rate
of return that exceeds the MARR. Choosing Alternative A
because of its larger IRR would be an incorrect decision. By
examining the incremental cash flows we see that the extra
amount invested in Alternative B earns a return that exceeds
the IRRso B is preferred to A. Also note

Pause and solve


Acme Molding is examining 5 alternatives for a piece of
material handling equipment. Each has an expected life of 8
years with no salvage value, and Acmes MARR is 12%. Using
an incremental analysis, which material handling alternative
should be chosen? The table below includes initial investment,
net annual income, and IRR for each alternative.
Alternative

Capital
investment

$12,000

$12,500

$14,400

$16,250

$20,000

Net annual
income

$2,500

$2,520

$3,050

$3,620

$4,400

12.99%

12.04%

13.48%

14.99%

14.61%

IRR

Comparing MEAs with unequal lives.

The repeatability assumption, when applicable, simplified


comparison of alternatives.
If repeatability cannot be used, an appropriate study period
must be selected (the co-terminated assumption). This is
most often used in engineering practice because product
life cycles are becoming shorter.

The useful life of an alternative is less than the


study period.

Cost alternatives
Contracting or leasing for remaining years may be
appropriate
Repeat part of the useful life and use an estimated market
value to truncate
Investment alternatives
Cash flows reinvested at the MARR at the end of the
study period
Replace with another asset, with possibly different cash
flows, after the study period

The useful life of an alternative is greater than the


study period.

Truncate the alternative at the end of the study period,


using an estimated market value.
The underlying principle in all such analysis is to compare
the MEAs in a decision situation over the same study
(analysis) period.

Equivalent worth methods can be used for MEAs


with unequal lives.

If repeatability can be assumed, the MEAs are most easily


compared by finding the annual worth (AW) of each
alternative over its own useful life, and recommending the
one having the most economical value.
For co-termination, use any equivalent worth method using
the cash flows available for the study period.

We can use incremental rate of return analysis on


MEAs with unequal lives.
Equate the MEAs annual worths (AW) over their respective
lives.
A
B
Capital Investment

$3,500

$5,000

Annual Cash Flow

$1,255

$1,480

Useful Live (years)

Solving, we find i*=26%, so Alt B is preferred.

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